Quantifying Uncertainty and Risk

Managing Risk - Some Simple Rules

Managing Risk

Investors can manage their risk in picking individual stocks by following some simple rules:

•  Require that the company have at least five years of financial history. Younger firms haven’t developed enough of a track record for assessing management performance.
•  Study only companies that have proven they can make money. Someone who invests in a company that has never reported earnings is speculating, not investing.
•  Understand the possible risk and reward of owning a stock.
•  Diversify your portfolio. Even if you’ve done your homework on every holding using all the information you need to make an informed decision, you’ll still make mistakes. If you have a good-size basket of stocks, however, you’ll also have some stocks that perform much better than expected.
 
Besides investing in high-quality growth stocks and diversifying your portfolio, two other simple principles can help you build wealth over the long term. 

• First, reinvest all your dividends and earnings. 
• Second, invest regularly in both good markets and bad; this is often called dollar-cost averaging.

 
The type of analysis outlined provides a lot of the information fundamental investors need to determine whether a stock is a suitable investment. But not everything. Reading annual reports, listening to conference calls and viewing company presentations will help you form a fuller picture of the company.
    
In today’s unpredictable, volatile market, fundamental analysis is even more important than usual. But for an investor using a simple, straightforward methodology that focuses on the long term, these are also times of great opportunity.

Reducing Portfolio Risk

The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. 

Portfolio management requires 

• paying attention to the portfolio as a whole, 
• taking into account diversification, 
• possible hedging strategies, and 
• the management of portfolio cash flow. 

In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.

Appropriate Diversification

Even relatively safe investments entail some probability, however small, of downside risk.  The deleterious effects of such improbable events can best be mitigated through prudent diversification.



The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great, as few as ten to fifteen different holdings usually suffice.



Diversification for its own sake is not sensible.

• This is the index fund mentality if you can't beat the market, be the market.  
• Advocates of extreme diversification - which I think of as over-diversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great.  
• My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings.  One's very best ideas are likely to generate higher returns from a given level of risk than one's hundredth or thousandth best idea.

Diversification is potentially a Trojan horse.

• Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk.  Investors who believed them substituted diversity for analysis and, what's worse, for judgment.  
• The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little,  is highly risky.  
• Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction.  

Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.

Unlike return, risk is no more quantifiable at the end of an investment than it was at its beginning.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.

Risk simply cannot be described by a single number.  

Intuitively we understand that risk varies from investment to investment:  a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about the risks the way food packages provide nutritional data.

Rather, risk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment.

• If exploratory oil well proves to be a dry hole, it is called risky.  If a bond defaults or a stock plunges in price, they are called risky.  
• But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made?  

Not at all.  The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made. 


There are only a few things investors can do to counteract risk:

• diversify adequately, 
• hedge when appropriate, and 
• invest with a margin of safety.  

It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount.  The bargain element helps to provide a cushion for when things go wrong.